The recent collapse in automobile sales is one symptom of the aggregate demand shock that has hit the Indian economy. The government said last week that the economy expanded in the three months to June at its slowest rate in 25 quarters. There has been an ongoing debate on whether the slowdown emanates from the supply side or the demand side. The answer lies in the inflation trend.
Consumer price inflation was in double digits during the previous downturn in 2013. It is now one percentage-point below the inflation target of 4%. Even core inflation has come down sharply, as companies lost pricing power because of weak demand. In a very simple analytical framework, slow growth with high inflation suggests supply-side rigidities, while slow growth with inflation below target suggests demand weakness.
So, 2019 is quite different from 2013.
The sharp slowdown in output growth combined with low inflation has pushed nominal gross domestic product (NGDP) growth to perhaps its lowest level in 15 years. This has potentially serious consequences if there is no quick recovery. First, the cost of borrowing for most companies will be higher than nominal growth. Second, the budget estimates for tax collection are also at risk, though a wider fiscal deficit because of a revenue shortfall could act as an automatic stabilizer.
Much of the debate till now has remained focused on whether macroeconomic policy needs to be eased through some combination of a higher fiscal deficit, lower interest rates, a weaker rupee and structural reforms. However, this column looks at another set of data that has not received enough attention in recent discussions about the slowdown. It is worthwhile to look at monetary data as well, especially how much Money is available for economic transactions, how people choose to hold this money, and how rapidly it is circulating in the economy.
Here are a few monetary facts from the annual report released by the Reserve Bank of India (RBI) last week.
First, reserve money in the 12 months to June grew at 14.5%, or close to its average over the past decade. Also, the Indian central bank expanded its balance sheet faster than the growth in nominal GDP, mainly through open market operations rather than dollar buying.
Second, the growth in the RBI balance sheet was largely driven by the rapid increase in currency in circulation, which accounted for 87% of the increase in reserve money. Some of this could be explained by higher demand for cash in an election year, but a large part must be because of the remonetization of economic activity.
Third, growth in broad money (M3) was slower than growth in reserve money by almost four percentage points. In other words, the incremental Money Multiplier was less than one. The overall money multiplier, or the ratio of broad money to reserve money, has fallen to its levels before demonetization. It was at 5.68 in 2018-19.
Fourth, the money multiplier by itself provides few analytical cues. The key to understanding what has happened is to take a look at another monetary ratio—currency with the public as a proportion of bank deposits, which depends on individual behaviour. It has gone up from 1.25 in 2016-17 to 1.41 in 2018-19, as people have rebuilt their cash holdings. This is inversely related to the money multiplier.
Fifth, the income velocity of broad money has climbed, but the income velocity of Narrow Money has fallen. Narrow money is cash and demand deposits. Narrow money is circulating at a slower pace in the economy. It is perhaps another indication that people have been rebuilding their cash holdings in recent quarters, especially since lower interest rates reduce the opportunity cost of holding paper money as opposed to keeping it in bank deposits.
The simplified bottom line is as follows. Indians are reverting to the old habit of holding large amounts of cash, though the rise of digital money is a welcome change. The rebuilding of cash holdings after the demonetization shock has altered several key monetary ratios, from the money multiplier to the income velocity of narrow money.
“The key behavioural parameters that drove the formation of monetary aggregates converged gradually towards their demonetization trends during 2018-19,” the central bank said in its annual report. It is not clear whether the normalization of monetary parameters has led to the disinflationary demand slowdown or whether it is the other way around. That requires more careful statistical analysis.
In a prescient article written in November 2016, Avinash Tripathi of The Takshashila Institution had brilliantly anticipated some of these monetary developments: “It is true that the current shortage of currency in India is temporary and it is hoped that the economy will bounce back once liquidity conditions improve. But by that time, the velocity of money will slow down because people will hoard cash rather than spend it, an output gap… will develop, deflationary expectations will have set in and the economy would be in a slowdown mode.” Seems familiar?
There are multiple ways to look at any economic downturn, from the impact of global shocks to a domestic credit squeeze to policy errors to depressed expectations. However, the role of monetary dynamics in such downturns should not be ignored. The ongoing Indian debate should take this into account.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics.
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